Small-Caps at All-Time Highs, But Can It Last?

by Dan Burrows | January 9, 2013 8:40 am

After lagging the broader market for much of 2012, small-cap stocks are back where they’re supposed to be in bull markets: a position of leadership.

That either means stocks have more room to run (despite the latest bull market getting to be rather long in the tooth), or maybe — just maybe — U.S. equities in general are getting a bit ahead of themselves.

Recession in much of Europe, slower growth in China, decelerating corporate profits and anxiety over the fiscal cliff couldn’t keep stocks down in 2012. The S&P 500 shrugged off a serious spring and summer selloff to put up a healthy annual gain of more than 13%.

And yet for much of the year, small caps actually lagged the broader market. The risk-on trade should have had shares of smaller companies jumping, but they’ve only pulled ahead recently, with the substantial outperformance coming in just the last month or so.

Indeed, the small-cap benchmark Russell 2000 set an all-time closing high of 879 on Jan. 4. In the past month, it has jumped 6%, beating the broader market by nearly 3 percentage points.

A number of things are working in small caps’ favor. These companies tend to derive more of their revenue from at home than abroad — no small matter when global economic weakness and a stronger dollar are working against companies with lots of sales coming from overseas.

As the fourth-quarter earnings season gets under way[1], the S&P 500 — which skews toward larger-cap stocks — is forecast to post aggregate profit growth of just 2.4%, according to FactSet data. That’s down from an estimated earnings growth rate of 9.2% as recently as Sept. 30. Companies in the small-cap benchmark S&P 600 index, however, are forecast to post earnings growth of 4.5%.

Chalk it up to the fact that although the U.S. economy grew at just a 3.1% annualized rate in the third quarter, that’s still better than just about any other major economy in the developed world.

Furthermore, with the housing market looking to have definitively made a turn for the better, the macro backdrop for the U.S. economy — and small caps — is relatively brighter.

Healthy corporate balance sheets and cheap and easy access to corporate credit are also helping small-cap companies, since they tend to be bigger borrowers.

Still, as we noted heading into earnings season, stocks have come very far, even as earnings growth has slowed to barely a crawl. Ultimately, share prices are supposed to move in anticipation of profits … meaning the market’s reprise of what has become an annual summer swoon could once again be in the offing.

So be careful in your allocation. Small-caps are riskier and more volatile that the S&P 500. When they move to either the upside or downside, they do so in more dramatic fashion. In 2011, for example, the S&P 500 lost 17% from early July to early August. The Russell 2000? It lost more than 23% over the same span.

Although it’s certainly good and optimistic to see small caps outperforming the broader market, just remember that in any big selloff, they’ll be leading the way down, too.